The diagram shown above explains how costs are assigned to a product under the ABC approach. ABC first assigns costs to the activities that are the real cause of the overhead and then assigns the cost of those activities only to the products that are actually demanding the activities.
ABC allocates overheads in a two-stage process. The first stage allocates overhead costs to activity cost pool (Cost Pool A, B or C as shown above). Activity cost pool is the overhead cost attributed to a distinct type of activity. Example of overhead cost pools are ordering materials, setting up machines, assembling products, inspecting products. The second stage assigns the overhead allocated to the activity cost pools to the products (Product A, B & C), using cost drivers for e.g. number of purchase orders, number of setups, labor hours, or number of inspections. (Jerry J. W., Paul D.K., Donald E. K. 2008). The cost drivers measure the number of individual activities undertaken to produce products or provide services. Therefore, they are helpful in order to trace indirect costs to products and in providing two roles for management accountants i.e. assigning the costs to cost objects and explaining cost behaviour.
Activity Based Budgeting is an approach to the budgeting process that focuses on identifying the costs of activities that take place in each area of a business and in determining how those activities relate to one another. The above diagram lays down the link betwe...
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...out the complexity of real operations and accurately assigning costs to products in a way that is in line with the method in which the activities are consumed. As a result, excess capacity costs are not directly assigned to products. Product costs are therefore not distorted by automatically burdening them with the cost of unused capacity. This helps the management take action based on the unused resource capacity. Furthermore, it can scale easily to handle large number of transactions while still delivering fast processing times and real-time reporting.
Therefore, with the increasing success of ABC system the way in which companies operated start changing. This required the budgeting and management system of firms to be in line with activity based approach, thus leading to the implementation of ABB and ABM which were complementary to the successful running of ABC.
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